The Federal Reserve Bank of New York works to promote sound and well-functioning financial systems and markets through its provision of industry and payment services, advancement of infrastructure reform in key markets and training and educational support
to international institutions.

The New York Fed engages with individuals, households and businesses in the Second District and maintains an active dialogue in the region. The Bank gathers and shares regional economic intelligence to inform our community and policy makers, and promotes
sound financial and economic decisions through community development and education programs.

Authors Antoine Martin and David C. Mills discuss a policy proposal by the Board of Governors of the Federal Reserve System regarding the extension of daylight overdrafts to banks by the Federal Reserve in the context of the central bank’s management of its exposure to credit risk. Daylight overdrafts can be interpreted as very-short-term credit that allow qualifying banks to obtain intraday liquidity by overdrawing on their accounts at the Fed.

The Federal Reserve’s Payments System Risk policy provides a framework by which the Fed manages its exposure to this type of credit risk. Currently, the Fed uses a variety of management tools, including overdraft fees, reputational risk to banks, monitoring of the banks’ actions and collateral. In March 2008, the Board published a policy proposal to increase the use of collateral as a credit risk management tool.

Martin and Mills outline potential benefits and costs associated with the proposal from the perspective of the Fed, banks and the financial system. The authors conclude that it may be desirable for a central bank to use a combination of tools to manage the credit risk associated with the provision of liquidity. However, the relative role of each tool in enforcing credit arrangements should depend on the details of the contractual relationship considered.

Antoine Martin is a research officer at the Federal Reserve Bank of New York; David C. Mills is an economist at the Board of Governors of the Federal Reserve System.